The common view of the cryptocurrency landscape is that it’s the Wild West — untamed, with speculative activity out of control, and with regulators bearing down, eyeing a new slew of laws and guardrails that must be crafted and implemented post-haste.
The rhetoric is heated, to put it mildly.
Even U.S. Securities and Exchange Commission Chair Gary Gensler referenced the “Wild West” classification earlier this summer when he said watchdogs needed to crack down on the fraud and abuse in the crypto world. He also said there must be more troops and a broader mandate to regulate exchanges and trading platforms.
Those comments and others, from the likes of Sen. Elizabeth Warren and Treasury Secretary Janet Yellen, point to the urgent need to rein in abuses and the threat to the financial system at large.
But as Ashley Ebersole, a Washington-based securities and financial regulatory partner with Bryan Cave Leighton Paisner and a former SEC enforcement lawyer, told Karen Webster in a recent interview, we’ve already got the laws and the infrastructure in place to regulate cryptocurrencies in ways that would benefit all stakeholders.
A Meeting of the Minds
Accomplishing that, however, will take a meeting of the minds between the enforcers and the private sector to help cryptocurrencies move beyond speculation.
As Ebersole said, for cryptocurrency or decentralized finance (DeFi) generally to reach its full potential, “regulators need to figure out what their stance is going to be. And hopefully it’s going to be a more reasonable and accommodative one.”
The reality of the crypto arena is that it’s not as wild and woolly as some critics might charge.
Ebersole noted that the “Wild West” tenor of the cryptocurrency industry had been tamed a bit — certainly since his own time with the SEC, which stretched from 2015 to 2019.
Back then, he told Webster, with the rise of initial coin offerings (ICOs) and various crypto-related touts, “there were people who did not have legitimate projects — they were just trying to perpetrate fraud. There are fewer of those types of projects these days, and the market has matured a bit.”
That means we’re less likely these days to see significant sums of money being committed to products and projects that do not have coherent compliance strategies in place. That’s moved the industry away from the “do it yourself” mindset that marked the end of the last decade, when individuals and firms thought they could (or should) create new assets and exchanges without the aid of lawyers or regulators.
Ebersole noted that while DIY coin offerings can be attractive to decentralization advocates, that strategy would be akin to launching a broker/dealer on Wall Street without the input of a securities lawyer to illuminate risks, liabilities and compliance burdens. Obviously, DIY is not an optimal strategy when large sums of money change hands between various parties and counterparties.
The What and the How
As things have calmed down a bit, and as cryptos have entered the mainstream, it’s important to understand the what — as in just what cryptos are — and the how, which is how they should be governed.
As to the what, the ongoing XRP/Ripple case — where the SEC filed suit last December alleging that Ripple issued and sold unlicensed securities to the public at large — will provide some answers.
Broadly speaking, the SEC contends that XRP is a security and therefore should be regulated as such. Ripple says the token exists as a medium of exchange, used in domestic and international transactions, so it should not be treated as a security.
Much hinges on the applicability of the 1946 U.S. Supreme Court case SEC v. W.J. Howey Co. (and, by extension, the Howey Test derived from that case), which found that “investment contracts,” a type of securities, involve an investment of money in a common enterprise, with an expectation that profits from the entrepreneurial or promotional efforts of others. The SEC broadcast with the 2017 “DAO Report” that the securities laws could apply to digital assets, and in 2019 offered up a framework illustrating how Howey is applied to digital assets.
The regulators contend that crypto players need oversight, but those entities argue that using 80-year-old law to regulate digital technology is a folly. But as Ebersole asked rhetorically, why wouldn’t Howey — which is based on principles, after all — be applicable? And, he added, maybe it’s the case that applying Howey yields the conclusion that XRP is not a security.
“There’s a reason the SEC’s lawsuit focuses on historical conduct. If you look at something like Ripple today,” he said, “you’re going to see an ecosystem that may be sufficiently decentralized that it would not be classified as a security anymore.” Extrapolate a bit, and depending on the level of decentralization, contended Ebersole, the SEC would likely have to “defer” enforcement jurisdiction over XRP to the overseer of the derivative markets, the Commodity Futures Trading Commission (CFTC).
If that were to happen — alongside the ongoing movement toward decentralization and the rise of decentralized finance as well as a shift away from SEC oversight — questions would loom about consumer protection.
“I think it’s going to be tough for these markets and instruments to reach the size and potential that many have forecast for them without some sort of regulation being imposed,” said Ebersole.
DeFi’s Model: The Card Networks?
Ebersole stated that one can still buy DeFi coins and other cryptocurrencies and conduct transactions in them on centralized exchanges.
And in that ecosystem, it’s conceivable that a centralized exchange could put a mechanism in place similar to that of credit card networks and issuers — and could stipulate that if someone conducts a transaction with a crypto coin and it turns out the counterparty was fraudulent (and money was lost), the exchange itself would absorb that loss, instead of the sender or retail investor. The advantage for that exchange, with a safety net in place, would be onboarding risk-averse individuals and investors who otherwise would not be in the crypto space at all.
As DeFi moves cryptocurrency transactions away from the exchanges, though, we may see the SEC and other agencies — if they see or suspect fraud — issuing subpoenas or cease and desist orders to Amazon Web Services or other players that provide the infrastructure or pipes that enable the movement of cryptos and smart contracts through the cloud.
To get toward a “reasonable and accommodative” regulatory environment, said Ebersole, the crypto firms themselves — the exchanges and the issuers — may need to soften their approach toward the regulators. The mindset that the SEC is simply out to “get” them, and is keen on filing enforcement action after enforcement action, is an unproductive one, though history may mean it continues to have staying power.
Any reasonable regulation should leave room for input from the “industry side” of the equation, the private sector itself — and according to Ebersole, these firms can then suggest workable regulations and that it would be sensible to impose.
Safe harbor initiatives — which let crypto firms launch projects with a predefined “grace period” before regulations kick in — or detailed discussions where regulatory actions are “off the table” could also prove useful.
“If the two sides can sort of lay down their swords a bit — or at least sheath them — and sit down and have a discussion … well, that would be the way to go,” maintained Ebersole.